Root Causes of Financial Crisis in the 1990s

IntroductionThe objective of this story is to discuss the root causes of financial crisis in the 1990s. In this light, the paper has identified financial liberalisations that occurred in the late 1980s as a principal cause of crisis in the 1990s. The paper begins by presenting a discussion of financial liberalisation in component part 2 below and then focuses on how it resulted in financial crisis in the 1990s. The paper employs the East Asiatic Financial Crisis as a case take apart and provides a discussion of how financial liberalisation contributed to the crisis 1997/1998 in section 2 while section 3 provides general conclusions and recommendations of the paper.Financial Liberalisation and the East Asiatic Financial CrisisOne of the main causes of financial crisis in the 1990s was financial liberalisation which facilitated the flow of working capital letter crossways borders. In the late 1980s and early 1990s, most developed and developing economies liberalised their finan cial systems and removed a number of regulations regarding the style of funds. In particular many countries eliminated restrictions on immaterial exchange movement thus increasing the flow of cross-border capital. One major crisis that occurred during the 1990s was the Asian Financial Crisis. This crisis has been linked directly to an step-up in cross-border capital flows which resulted to coin crisis across the East Asian Countries that were involved in the crisis. Most of the countries involved in the crisis witnessed disparagement in their currencies which in turn led to major crisis across on the whole the countries involved. Siameseland was facing competition for its exports which led to a decline in its export sales. One of the reasons for Thailands export declines was as a result of the devaluation of the Chinese yuan in 1994 (Pathan et al., 2008). Rising export competition Thailand forced many businesses to shift from manufacturing to the real estate. Banks began pro viding loans to home buyers to facilitate real estate investments. A banking facility The capital of Thailand International Banking Facility (BIBF) offered funds to both local and opposed borrowers thus facilitating their real estate investments (Pathan et al., 2008 Bisgnano, 1999).In the early 1990s, the East Asian countries were witnessing significant economic growth. As a result, these economies maintained huge incumbent account deficits (Bird and Rajan, 2000). As a result, large inflows of capital and a depreciation of international reserves were compulsory to reduce finance the deficits (Bird and Rajan, 2000). During This period, many East Asian economies also made significant efforts to liberalise their domestic financial systems as well as the capital account balance of payments. The establishment of the BIBF in Bankgok is a typical example of how domestic liberalisation facilitated the attraction of foreign capital. It enabled domestic banks to accept foreign-currency-d enominated loans and deposits from foreign investors. These loans were subsequent use to offer loans to the domestic market. This process led many local firms to increase their leverage thus increasing their financial risk.Net capital inflows for altogether countries in the region were positive and most often than not exceeded the current account deposit. In addition, international reserves were significantly high (The terra firma Bank, 2000). detonating device inflows were significantly high in Malaysia and Thailand. These countries were classified among the top ten emerging market economies to received net private capital flows during the period under aim (Lopez-Mejia, 1999).A significant portion of the loans were made in foreign currency. This strategy increased the gearing of many foreign and local borrowers. The huge influx of capital combined with high current account and trade deficits in the first half of the 1990s resulted in the massive decline in the value of the c urrencies of the region, which in the end transformed into the financial and economic crisis of 1997 and 1998. Moreover, most of the countries involved in the crisis were operating a semi-pegged exchange rate regime, which also contributed to the currency crisis.Significant movements in the Thai Bhat meant that the currency could no long-lived sustain its value. the currency was forced to crash in 1997. On the 2nd of July 1997, the Thai Bhat was allowed to float freely and its value bring down tremendously against other currencies (Joosten, 2004 Pathan et al., 2008). Despite the introduction of foreign exchange controls as well as large spot and forward interventions by the government and important bank, the magnitude of the disaster on the currency was so high that these measures could not stop it. As a result, the devaluation of the Thai Bhat on the 2nd of July 1997 marked the bombardment of the East Asian Financial Crisis (Joosten, 2004 Li and Kwok, 2008). The currency crisi s in Thailand was transmitted to five other East Asian economies. As explained earlier, the main cause of the crisis was the relaxation of the financial system which led to large cross border movements in foreign currency. The large movement in the East Asian currencies led to their depreciation which eventually led to the crisis.capital of Singapore has often tried to compare itself to London as a major financial Centre. Consequently, U.S financial institutions often used it as a safe haven for depositing toxic assets. Given the liberalised nature of global financial markets, Singapore attracted a lot of toxic assets from the U.S which also helped in fuelling the crisis in Singapore (Lim and Maru, 2010).In Indonesia, the channel taken by the crisis was somewhat different from those of other countries like Korea and Thailand (Joosten, 2004). The Central Bank (Bank of Indonesia) increasing became concerned about an economic system that was operating higher up full employment and d ecided to take measures that would slow down the economy to ensure that it return to full employment. The Central bank all the same, lacked the tools requisite to reduce aggregate demand. This is because it became concerned that if interest rates were increased, more foreign capital would flow into the economy a situation that would result to a currency crisis. Lack of an appropriate monetary policy tool meant that the Central Bank was unable to prevent an imminent crisis.Like Indonesia, Malaysias economy was operating beyond full employment. During the year 1995, the country witnessed an increase in public investment. The money was spent mainly on large infrastructure projects (Joosten, 2004). By the end of 1996, the count, Malaysia witnessed a decline in its current account deficit and the concerns over capacity overutilization were reduced. However, given increasing concerns over the ability of other East Asian countries as good investment environments, investors began to perce ive Malaysia as a safe haven. Consequently, the country witnessed a huge influx of foreign capital which resulted in an increase in bank lending that in turn fuelled an asset boom. The influx in capital led to an increase in the countrys current account deficit over the period 1992-1995 as wel as declining exports. Huge current account deficits combined with trade deficits, the local currency could no longer sustain its value. This means that Malaysia could not escape the crisis either. The Philipines also had a sound economy when compared to other East Asian economies. The country operated at low levels of foreign debt and showed no immediate risk of a crisis. However, an influx in foreign capital soon fuelled a rapid lending boom that was mainly used in the financing of risky investments and as such the country began facing difficulties (Joosten, 2004).Table 1 Current Account (% of GDP). YearIndonesiaMalaysiaPhilippinesRepublic of KoreaThailand 1992-2.0-3.7-1.6-1.3-5.5 1993-1.3-4 .6-5.50.3-4.9 1994-1.6-7.6-4.6-1.0-5.4 1995-3.2-9.8-4.4-1.7-7.9 1996-3.4-4.4-4.8-4.4-7.9Source (Joosten, 2004).Table 1 above illustrates the current account as a percentage of GDP for the East Asian Economies that were involved in the crisis over the period 1992 to 1995. It can be find that all five countries exhibited a negative current account indicating that they operated current account deficits throughout the five year period leading up to the crisis. Korea however had a positive figure of 0.3% in the year 1993. Thailand showed the worst economic performance as evidenced by its largest current account deficit which unbroken widening with time.Conclusions and RecommendationsThe objective of this paper was to identify the root causes of financial crisis in the 1990s. Using the East Asian Financial Crisis as a case study, the paper concludes that one of the major causes of financial crisis in the 1990s was financial liberalization. Financial liberalization facilitated the moveme nt of capital across borders. The East Asian Economies liberalized their financial systems thereby allowing a huge influx of foreign capital. Given that most of these countries suffered trade deficits, the capital was spent mainly on infrastructural development which means that enough returns could not be realized to cover the current account deficits. As such the current account deficits had to be financed with international reserves. This resulted in a currency crisis across the region which eventually led to the financial crisis in 1997 and 1998. One of the main lessens that can be learnt from this crisis is that countries with huge current account deficits should not attract foreign capital if they are also operating trade deficits. This is because most of the foreign capital is used to finance unprofitable projects that cannot generate enough cash flows to jump the current account deficit. This increases the financial risks of both the private and public sector, which eventual ly result in a financial crisis.ReferencesBird, G. and Rajan, R. S. 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